The Austrian Business Cycle Theory was developed by the economist Ludwig von Mises to explain the phenomenon of business cycles. It provides crucial insight for understanding the cause of cyclical boom/bust cycles and their connection to the government’s manipulation of the economy. To understand the Austrian Business Cycle Theory, an analogy is helpful:
Imagine an economy with just one actor: Robinson Crusoe on an island. Crusoe loves fish, so he spends half of each day fishing so he can enjoy fish in the evenings. Additionally, Crusoe spends Friday mornings maintaining his fishing dinghy and nets. In order to have fish on Friday, he must fish for an extra hour every other day of the week. In economic terms, Crusoe has a savings rate of one hour per day. His savings rate is also his investment rate, or the percentage of present income he sets aside to maintain or increase future consumption.1
Crusoe doesn’t have a fridge, so he preserves his catch by throwing it in a small, dark pond. He can’t see how many fish are in the pond, so he keeps a stack of small rocks near it. Every time he adds a fish, he adds a rock, and every time he eats one, he removes one. The rocks are his money supply.
Suppose that Crusoe shares the island with some mischievous monkeys, who see Crusoe adding rocks to his pile. They decide to imitate him, so every time Crusoe ads a rock, they sneak in and add one as well. The monkeys are inflating the money supply by injecting currency into Crusoe’s investment fund.2
One day, Crusoe suddenly notices that his “savings rate” of fish is double the usual. He decides to compensate by eating some of the fish he catches during the “savings hour.” This is the consumption-side of the boom phase of the business cycle. Crusoe also decides to take some extra time each day to start building himself a new hut. This is the investment-side of the boom phase of the business cycle.
Crusoe now believes that the cost of saving fish is half the usual, while in fact his savings rate is too low for the investments he is planning.
Before long, Friday comes around. When it comes time to eat his midday meal, Crusoe suddenly realizes that he’s out of fish – despite having a surplus of rocks. He’s exhausted his investment capital because the additional currency snuck into his money supply did not represent a real increase in his productivity or savings rate. He doesn’t have the capital (fish) to maintain his previous consumption rate, much less increase it. He is forced to cut his investment rate (he must spend some of his Friday fishing) just to have some fish for Friday’s dinner. He must also abandon his incomplete hut because he does not have the time to finish it. The abandoned hut is an extravagant expenditure that represents a loss of capital.3 This is the bust phase of the business cycle.
To review, here’s the overall impact of the monkey’s trickery: Sunday-Friday, Crusoe catches the same number of fish, but consumes more, and therefore saves less. That’s the boom period. Friday, Crusoe consumes less fish, and spends less time for maintaining his nets (capital). Some of his investment/consumption time must now be spent in production. That’s the bust period. If Crusoe’s initial savings rate allows him to just break even each week 4, his nets will gradually get worse and worse and he will eventually go hungry.5
- Crusoe prefers to enjoy his fish sooner rather than later, but he is willing to put aside some of his catch to get more fish later. The discount he gives to eating a fish Friday is his time preference, or his originary interest rate. (To that, he adds the risk that the fish will spoil by Friday to get the market or “real” interest rate.)
- As long as the monkeys keep contributing one stone for every fish, Crusoe can account for their trickery. But if the monkeys are unpredictable, it will be impossible for Crusoe to set the proper savings rate. In the real world, the originary interest rate reflects the average time preference of all savers. If someone starts monkeying around with the interest rates, it becomes impossible for investors (or the monkeys at the Fed) to know what the real rate of savings is even if they know that the rate is being manipulated.
- That abandoned hut represents investments which exceed the ability of the actual savings rate to complete. The resources it takes to build compete with worthwhile investments (such as repairing the fishing nets) by raising the prices for all capital. Ridiculous business models and sky-high salaries during the dot-com boom, as well as over-extended sub-prime mortgages likewise compete with legitimate business models, salaries, and mortgages. Manipulating the money supply makes it difficult to distinguish bad investments from good ones, so no one can escape the inevitable crunch.
- That is, zero net profit, an equilibrium rate of savings, or “the evenly rotating economy” in Mises’ terminology.
- Suppose Crusoe decides to ignore his hunger and work on his nets all Friday. In other words, he trades current production (and therefore consumption) for higher future consumption (that is, economic growth). If he does so voluntarily, there’s nothing wrong with that. But there’s nothing inherently more desirable or efficient in spending some of one’s time starving just to increase future production (that is, in valuing economic growth over present consumption.) Note that the longer Crusoe delays the shift back to production, the more severe the mis-allocation of resources (and his hunger) becomes. The monkey’s trickery does not actually make Crusoe to become a better saver – he is more likely to start saving less because of uncertainty over the future.